Deflation a serious threat to investors

Posted on 22/08/2019 by

Low inflation in China is bad news for Asia Photo: David Rowe ‘We have no historic precedent to draw upon and asset pricing is moving in uncharted waters.’ Photo: Dorothy Woodgate
Shanghai night field

Deflation is the “most likely” scenario for most of the developed world, according to a gloomy note from Sydney-based Clime Asset Management, while Fidelity and HSBC have also echoed their concern about the spectre of falling prices.

Clime said the outlook for the world’s developed economies was one of lower growth and low inflation.

“We would therefore speculate that the most likely economic scenario for most of the developed world is deflation. A re-run of Japan’s decades of low growth but on a grander worldwide scale.”

Deflation is characterised by falling prices, as opposed to inflation, which is defined as rising prices. Economists consider deflation a threat because it increases the real value of debt and may aggravate recessions through a deflationary spiral.

Clime stated that the “inflexion point into this low growth era has been passed” and markets were realising that investment returns were going to be single-digit and consistent with low economic growth. The World Bank last week downgraded growth forecasts.

Clime said that “this economic period and the economic settings are unique in world economic history … we have no historic precedent to draw upon and asset pricing is moving in uncharted waters.”

Dominic Rossi, Fidelity’s Global CIO equities, also argued that deflation was likely – but unlike Clime, put the blame on emerging economies.

“Global equity markets are battling the third wave of deflation since 2008,” Mr Rossi told Fairfax Media.

“The epicentre now is not within the developed world nor the financial system but within the developing world and the global manufacturing sector, where capital allocation has been poor and where overcapacity is rife. A crisis in emerging currency markets has flagged these problems for 18 months.”

Mr Rossi said the catalyst for deflation was the Chinese yuan, falls in which will further deflate the demand for commodities and traded goods.

“Inflationary pressures will correspondingly remain tame to non-existent.”

Central banks in Europe and Japan would continue their “ultra-loose” monetary policies, while the Federal Reserve and the Bank of England faced the possibility of backtracking on their interest rate hiking cycles.

“Pressure…to raise interest rates will surely wane,” said Mr Rossi.

HSBC’s paper, “Feeling deflated still”, pointed out that China’s annual inflation result of 1.6 per cent, released on the weekend, was bad news for Asia.

“Sliding inflation poses a major headache for policy-makers in Asia,” said HSBC.

“First, it makes the already high level of debt harder to service, hurting demand. Second, it reduces the potency of any further monetary stimulus. Marginal rate cuts may still arrive in the coming months, including in Korea, China, Indonesia, , New Zealand and India. But they’ll not pack much punch.”

The paper cited HSBC’s chief China economist, Qu Hongbin, who argues that without “aggressive reflation” the drag on demand of falling inflation will only increase.

But monetary easing faced two constraints, the paper said.

“First, in many economies interest rates are already at such low levels that they leave little room for meaningful cuts (think Korea, Thailand, Taiwan). Second, with the Fed hiking and exchange rate volatility on the rise, overly aggressive easing could precipitate capital outflows, which would tighten, rather than ease, overall financial conditions.

“Conventional monetary policy is approaching its limits in much of Asia.”

That left fiscal policy.

“Government debt in much of the region (though not everywhere, such as in Japan, India, or Malaysia) appears low enough that pump priming remains an option. Qu Hongbin, for one, expects a meaningful fiscal boost in China this year. But elsewhere, with the exception of Japan, counter-cyclical fiscal policy is rarely a preferred tool, with the authorities generally pursuing a relatively conservative approach, often hemmed in by legal or self-imposed fiscal rules.”

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